Sunday, January 22, 2012

How Deflationary Forces Will Be Turned into Inflation

How Deflationary Forces Will Be Turned into InflationMises Daily: Thursday, January 19, 2012 by Thorsten Polleit

I.

The ongoing financial and economic crisis has not only stoked fears that it will end in inflation — as central banks will print up ever-greater amounts of money — but it has also given rise to a diametrically opposed concern: namely, that of deflation.

For instance, in December 2011 Christine Lagarde, head of the International Monetary Fund (IMF), warned that the world might risk sliding into a 1930s-style slump, such as the Great Depression.

This episode was characterized by worldwide defaulting banks, a shrinking of the money supply (or, deflation), which in turn led to falling prices across the board, sharply falling production and drastically rising unemployment.

In today's fiat-money regime — which contrasts with the gold-exchange-standard that was in place in many countries at that time — the possibility of deflation appears fairly small indeed.[1]

This becomes obvious if one takes a look at the workings of today's fiat-money system, a system in which the money supply can actually be increased at any point in time in any amount deemed politically desirable.

II.

Commercial banks need two ingredients to produce additional bank-circulation credit, through which the fiat-money supply is increased, namely, central-bank money and equity capital.

Central-bank money is a "monopoly product," produced by the central bank, typically through loaning to commercial banks.

Equity capital comes from investors who are willing to invest their money in commercial banks, thereby becoming owners of the banks.

Banks need central-bank money for three reasons. First, they have to hold a certain percentage of their liability vis-à-vis nonbanks in central-bank money; these are the so-called minimum reserves.

Second, banks need central-bank money for making payments in the interbank market. And third, banks keep central-bank money for meeting the cash drain, caused by clients demanding a cash payout of their deposits.

If, for instance, the minimum reserve rate for demand deposits is 2 percent, the banking sector as a whole can produce $50 of credit and fiat money with each $1 of central-bank money (that is 1 divided by 0.02).

Government regulation requires commercial banks to back up their "risky assets" (such as loans and securities) by a "minimum" equity capital. If, for instance, the minimum capital requirement is 8 percent, a bank can produce $12.50 of credit and money (that is 1 divided by 0.08) with a given $1 of equity capital.

If the risky weighting of risky assets is, say, 25 percent rather than 100 percent, a bank can produce credit and fiat money in the amount of $50 (that is $12.5 times 1 divided by 0.25). That said, a loss of $1 requires a bank to reduce its credit and money supply by $50.

Against this backdrop we find that the lower the minimum reserve ratio is, the more credit and fiat money the banking sector can produce with a given unit of central-bank money. And further, the lower the capital requirement and the risk weightings are, the higher will be the leverage banks can build up with a given amount of equity capital.

III.

From early 1960 up to the end of 2007, US banks' credit and money multipliers (which denote the amount of credit and money banks can produce with $1 in central-bank money) increased drastically — thanks to a continual rise in central-bank money, ever-lower reserve requirements, and readily available bank-equity capital.

For instance, with a central-bank money supply of $1, banks produced around $211 of bank credit in August 2008. This compares with less than $20 seen in the early 1960s.

In "fighting" the credit crisis, the US Federal Reserve increased US banks' (excess) reserves drastically as from late summer 2008. As banks did not use these funds (in full) to produce additional credit and fiat-money balances, however, the credit and money multipliers really collapsed.

The collapse of the multipliers conveys an important message: commercial banks are no longer willing or in a position to produce additional credit and fiat money in a way they did in the precrisis period.

This finding can be explained by three factors. First, banks' equity capital has become scarce due to losses (such as, for instance, write-offs and creditor defaults) incurred in the crisis.

Second, banks are no longer willing to keep high credit risks on their balance sheets. And third, banks' stock valuations have become fairly depressed, making raising additional equity a costly undertaking for the owners of the banks (in terms of the dilution effect).

For instance, in the euro area, bank stock prices fell by around 76 percent from the beginning of 2007 to the beginning of 2012 — unmistakably signaling investors' lack of confidence in the viability of many banks' business models. In the United States, bank stock price declines amounted to slightly more than 50 percent.

The latest developments suggest that banks are about (at least for now) to start scaling back their risky assets in relation to their prevailing capital base. In other words, banks are adopting a strategy of "deleveraging" and "derisking."

Such a strategy can be put into practice by, for instance, refraining from rolling-over maturing loans granted to, say, corporate, consumers, and public-sector entities — something that will in a fiat-money system result in a decline in the outstanding credit and fiat-money supply.

Alternatively, banks can reduce their risks by selling off assets so far recorded on their balance sheet. This would also reduce the outstanding money supply — as the buyers of bank assets would pay with existing demand deposits, which are thereby literally "destroyed."

Given that investors in bank capital become unwilling to expose their money to credit risks, let alone want to assume new credit risks, the fiat-money system, which has been highly inflationary in the last decades, would turn deflationary.